Last month the RBI governor Raghuram Rajan defended his decision not to cut interest rates by saying “ It is not the RBI’s business to deliver booster shots to the stock market so that stock markets can soar for a short while, only to collapse when reality hits….What is important for us is sustained low inflation…the RBI will have no hesitation in delivering once we are assured of the low inflation”. At the time when he said this wholesale price inflation was minus 4.1 percent; primary product inflation was minus 3.7 percent, fuel and power was minus 12.8 percent and manufactures minus 1.5 percent. So what inflation measure was Rajan talking about? The answer is the cost of living index.
But chief economic adviser Arvind Subramanian pointed out in an article in the Indian Express as long ago as June 12, that this is the only index he should avoid using, because its stickiness, and the widening gap between it and all other measures of inflation, makes it suspect. Subramanian had written that pegging policy interest rates to the cost of living made sense in “normal times”, but not in ‘unusual times’. ‘From the context it was clear that by normal times he meant those that had existed till 2007, when the CPI., although much more volatile than the WPI, had traced the same long term path.
Times became ‘unusual’ after 2007. Except for a few months at the bottom of the global recession in 2010-11, the gap between CPI and WPI has widened steadily from 3 percent in 2010 to an unprecedented 8 percent in August. What is more this has happened inspite of the RBI using every monetary instrument to squeeze demand and force prices down. The only conclusion one can draw is that whatever is keeping the CPI inflation up, it is not an excess of demand.
If not demand then what is it measuring? There is only one remaining candidate: shortages of supply. The association of inflation with excess demand is so hard-wired into our thinking that it is often hard to remember that inflation can also be caused by shortages in supply. The idea of politically inspired, artificially engineered, shortages that last for long periods, is alien to economists’ thinking because it comes from the dangerous realm of political economy. But once we open ourselves to this possibility it does not take long to see that it is, indeed, the reason why the behaviour of the CPI has changed so radically.
Foodgrain and cash crop prices ( hich account for more than 40 percent of the CPI) have become progressively less sensitive to demand because state governments are setting minimum support prices for more and more commodities. Today there are procurement , or minimum support, prices for more than 20 groups of food and cash crops, and the central and state governments have been raising these by five to seven percent every year for more than a decade.
The rise in price of urban housing, which accounts for 9.77 percent of the index, is almost entirely accounted for by the growing shortage of urban land. Tariffs on transport, fuel and lighting, which account for another 17.1 percent, rose sharply because of a revival of international oil prices till mid-2014, a 40 percent fall in the value of the rupee after 2011; a simultaneous removal of subsidies on diesel, gasoline and LPG, and a growing reliance on coal, imported at four times the domestic price, for power generation. All these are cost push factors that get translated into an increase in the cost of living through administered changes in price.
Health and education make up another 9.04 percent. The cost of the former has risen because of drug price decontrol – another administered price change — and because of a growing reliance on private health services. The rise in the latter reflects the final collapse of the public schooling system.
In sum , whatever the cost of living index may signify in countries where more than half of the population lives on pensions, in India it is an index not of excess demand but of the failures of past governments. To use these as a yardstick of inflation and curb industry is to destroy India’s future and administer the kiss of death to its poor.
The right policy is not to leave interest rates solely to politicians but link them to a measure that has been purged of all pressures caused by administered prices and shortages of supply. The only one in India that fully does this is CRISIL’s Core rate of Inflation Index (the CCII) .
The CCII is derived from the RBI’s Non-Food Manufactures Index (NFME) but excludes oil and metals because their prices are heavily influenced by global price trends. But it also includes manufactured foods and beverages, which the NFME excludes. This measure of inflation has stayed close to the wholesale prices index, but is far more stable. In September 2014 when the fall in oil prices had just begun to bring down all indices of inflation, the RBI’s NFME fell to 2.8 percent and the wholesale price index to 2.38 percent, CCII index will not have fallen as much as the WPI but is almost certainly also showing deflation. Today, India desperately needs investment in infrastructure, and therefore the lowest possible long term interest rates. With the CCII at a long term rate of at most two percent thus there is not an iota of economic logic for keeping bank lending rates at 12 percent.Read More